1. Demand and supply analysis – part 2
Econ 100
Lecture 5
The determination of prices and quantities of goods in perfectly competitive markets:
Demand and supply analysis – part 2 1

2. In this lecture, we are continuing with our plan of topics outlined in the last lecture:
Markets (competitive markets and others)
Demand (buyer side of a competitive market)
Supply (seller side of a competitive market)
Equilibrium (determination of price and quantity as a result of the interaction between demand and supply)
Changes in equilibrium (changes in price and quantity) 2

3. We have already discussed markets (what they are and different types of markets) and demand side of a perfectly competitive market.
So let us continue by starting to examine the supply side of a perfectly competitive market. 3

4. Recall the following two definitions:
Quantity demanded = the number of units of the good that the buyers are willing (and able with available means to them, such as their income) to buy over a given period of time
Quantity supplied = the number of units of the good that the sellers are willing (and able with available means to them, such as their inventories or production capacity) to sell over a given period of time 4

5. Supply
The discussion of the supply side of the market deals with the factors that affect / determine the quantity supplied.
We can talk about two different quantities supplied:
Individual quantity supplied – quantity supplied by an individual seller
Market quantity supplied – quantity supplied by all sellers in the market which is the sum of all individual quantities supplied
Either of these are determined by a number of factors. 5

6. Quantity supplied of a good is determined by...
Price of the good itself
Input prices
Technology
Prices of other goods (that the seller(s) is (are) or could be producing)
Expectations (expected future price of the good, expected sales in current period, …) by (all) the seller(s)
Number of sellers (if it is the market quantity supplied)
... 6

7. The relationship between individual quantity supplied and the price of the good
The quantity supplied by an individual producer or seller is positively related to the price of the good.
In other words, individual quantity supplied (qS)
increases as the price (P) of the good increases and
decreases as the price of the good decreases.
The exact properties of this relationship may be different depending on the good and the individual producer in the sense that...

8. as P changes, the change in qS may be
continuous or stepwise
large or small
but the fact remains that qS will go in the same direction as P goes.
What is the reason behind this positive relationship?

9. As P increases and the good becomes relatively more expensive, producing and selling this good becomes (relatively) more profitable for the individual producer or seller so that the individual will switch to the production of this good from other activities or from producing and selling other goods.
If it is possible to produce more of this good with relative ease or difficulty, the change in qS as a result of a change in P will be relatively larger or smaller.

10. One can draw the graph of this relationship in general by
Using the horizontal axis to measure qS
Using the vertical axis to measure P
Drawing a positively sloped curve
This graph will display the relationship in a general way because for a specific good and a certain individual producer we may actually have a continuous curve or a stepwise function ascending like a staircase in the + direction along the horizontal axis, or a relatively flat or a relatively steep curve.

11. Sticking with the general case, we see that if A, B, and C are three points on this curve, it shows that
as the price of the good is equal to PA, the quantity supplied by the individual seller will be equal to qSA,
and if P increases to PB, qS will increase to qSB,
and if P decreases to PC, qS will decrease to qSC.
so that as P changes we move from one point on the curve onto another one.

12. The positive relationship between qS and P is called the supply (for a specific good by a certain individual seller) and
the positively sloped curve which is the graph of the relationship between qS and P is called the supply curve (for a ...).
In order that the supply curve really displays the relationship between qS and P, it has to show the effect on qS of P only.
In other words, it has to show how qS changes as P and only P changes without any change in any one of the other factors that can affect qS.

13. This means that all factors other than P must remain constant along the supply curve.
In other words, the supply curve must be drawn such that, if for example the wages of a typical worker employed by the individual producer is equal to 2500 TL per month at one point on the supply curve, it has to be also equal to 2500 TL per month at another point on the supply curve.
So the supply curve shows the effect of P on qS everything else remaining the same or constant.

14. Factors that remain constant along an individual supply curve
Not the price of the good itself, of course, but
Input prices
Technology
Prices of other goods (that the seller is or could be producing)
Expectations (expected future price of the good, expected sales in current period, …) by the individual seller
...

15. Individual supplies and market supply
Consider two individual producer/sellers A and B and their individual quantities supplied resulting in the market quantity supplied (assuming there are only two sellers):
Price Quantity supplied (no of units)
(TL/unit) by A by B market

16. Market supply is the horizontal sum of individual supplies.
Compared to the individual supply curves, the market supply curve is relatively
flatter
shifted out more
Almost everything we noticed about individual supply (curve) applies to market supply (curve) as well.

17. The relationship between market quantity supplied and the price of the good
The market quantity supplied is positively related to the price of the good.
In other words, market quantity supplied (QS)
increases as the price (P) of the good increases and
decreases as the price of the good decreases.
The positive relationship between QS and P is called the supply (for a specific good by all sellers in the market) and
the positively sloped curve which is the graph of the relationship between QD and P is called the supply curve (for a ...).

18. In order that the supply curve really displays the relationship between QS and P, it has to show the effect on QS of P only.
This means that all factors other than P must remain constant along the supply curve.
So the supply curve shows the effect of P on QS everything else remaining the same or constant.

19. Factors that remain constant along a market supply curve
Not the price of the good itself, of course, but
Input prices
Technology
Prices of other goods (that the sellers are or could be producing)
Expectations (expected future price of the good, expected sales in current period, …) by all the sellers
Number of sellers
...

20. We have seen that as P changes, (individual or market) quantity supplied changes along the supply curve. So we can see the effect of a change in P as a movement along the supply curve.
What if one of the other factors, for example price of an input, changes?

21. What is an input?
Inputs = Resources (such as labor, capital etc) as well as other goods and services (raw materials, parts, energy) used in the production of the good whose quantity supplied we are considering
The counterpart of this term is output.
Output = the good produced by using a certain set of inputs
Sometimes the term output is used to refer to the quantity produced of the good.

22. Example: You are running a bakery producing and selling cakes.
Output: cakes
Inputs:
Labor (of the cooks, sales people)
(Physical) capital (ovens, mixers, other kitchenware, the building in which the kitchen and the shop are located)
Raw materials (ingredients like flour, eggs, sugar, raisins, chocolate etc)
Electric power to run the ovens and illuminate the building

23. The relationship between quantity supplied and input prices
As the price of an input increases, costs of producing the good increase.
As production costs increase, it will be less profitable to produce and sell this good.
Producers will be willing to produce less of this good at any price.
This means that the quantity supplied will decrease.
Hence, there is a negative relationship between quantity supplied of a good and the price of an input used in the production of that good.

24. Suppose now we would like to see the effect of a change in input prices (or of any factor other than the price of the good) on the same diagram as the supply curve,
In order to be able to do that...

25. we would have to
use the horizontal axis to measure quantity supplied as before, and
use the vertical axis to measure price of the good instead of the input price, and
draw the supply curve.
Now since we are trying to see the effect of a change in the price of an input only, everything else, including the price of the good, will have to remain the same.
This implies that, if the quantity supplied decreases as the input price increases, it decreases at the same price of the good.

26. which in turn implies that we move onto a new supply curve or
the supply curve shifts (and it shifts left if quantity supplied decreases).
We see that the effect of a change in any factor other than the price of the good is seen as a shift in the supply curve.
We can summarize that there are two types of changes:

27. Either
the price of the good changes
causing the quantity supplied to change
which is seen as a movement along the same supply curve. or
any factor other than the price changes
causing the supply to change
which is seen as a shift in the supply curve.

28. Notice that the following three are equivalent expressions (they express the same thing):
Quantity supplied increases at any price
Supply increases
Supply curve shifts out
Also, it is equivalent to say the supply curve shifts
out
right
down

29. Effects of some of the other factors on quantity supplied
Input prices (–) (QS decreases at any P or S decreases or S curve shifts in)
Prices of other goods (–)
Expectations
Expected future price (–)
Expected sales in current period (+) (QS increases at any P or S increases or S curve shifts out)
Number of sellers (+)

30. Demand and supply together: Equilibrium and disequilibrium
Now that we studied the buyer and seller sides of the market separately, it is time to look at the interaction between buyers and sellers.
Conceptually, this means that we put demand and supply together.
Graphically, this amounts to drawing the demand and supply curves on the same diagram.
What strikes your attention first if you look at such a diagram?

31. The demand and supply curves intersect at a point (what if they do not
The demand and supply curves intersect at a point (what if they do not?) and the price going in the market may be equal to, less than, or greater than the price at which they intersect.
Let P be the price going on in the market and Pe be the price at the point at which D and S curves intersect. The possibilities are:
P > Pe
P < Pe
P = Pe
Let us consider each of these possibilities separately.

32. P > Pe
Suppose first the price going in the market happens to be equal to P1 which is larger than Pe.
At P1, market quantity demanded will be QD(P1), market quantity supplied will be QS(P1), and we will have QD(P1) < QS(P1).
In other words, buyers are willing to buy a smaller number of units of the good than the sellers are willing to sell, and consequently, sellers will not be able to find a buyer for each and every one of all units that they want to sell.
Such a situation is called a surplus or excess supply.

33. Since sellers are not able to sell all they want, they will sooner or later begin, one after another if not all more or less at the same time, to cut down the price they are charging, and the market price will begin to go down.
As P decreases,
QD will increase along the D curve and
QS will decrease along the S curve,
causing the surplus to decrease as well.

34. But as long as there is some surplus, sellers will still find themselves left with unsold units of the good, being forced to continue to cut their prices.
Therefore the market price will continue to fall as long as
there is a surplus or
market quantity demanded is less than the market quantity supplied
which means that P will fall until the intersection point is reached.

35. P < Pe
Suppose now the price going in the market happens to be equal to P2 which is less than Pe.
At P2, market quantity demanded will be QD(P2), market quantity supplied will be QS(P2), and we will have QD(P2) > QS(P2).
In other words, buyers are willing to buy a larger number of units of the good than the sellers are willing to sell, and consequently, buyers will not be able to find as many units as they want to buy, and some buyers even may not be able to buy any units at all.
Such a situation is called a shortage or excess demand.

36. Sellers will see that they are not being able to meet the demands by all customers, some of whom may make it clear that they would be ready to pay a higher price if only they could find some units to buy. So, realizing that they could increase their prices without losing sales, sellers will sooner or later begin, one after another if not all more or less at the same time, to raise the price they are charging, and the market price will begin to go up.
As P increases,
QD will decrease along the D curve and
QS will increase along the S curve,
causing the shortage to decrease as well.

37. But as long as there is some shortage, sellers will still be able to increase their prices without losing sales, finding it profitable to continue to raise their prices.
Therefore the market price will continue to rise as long as
there is a shortage or
market quantity demanded is larger than the market quantity supplied
which means that P will rise until the intersection point is reached.

38. We can summarize the two cases we examined as follows:
If the market price is too high
there will be a surplus or excess supply and
the price will begin to decrease.
and
if the price is too low
there will be a shortage or excess demand and
the price will begin to increase.

39. P = Pe
Finally, suppose the price going in the market happens to be equal to Pe.
At P = Pe, market quantity demanded will be QD(Pe), market quantity supplied will be QS(Pe), and we will have QD(Pe) = QS(Pe).
In other words, buyers are willing to buy exactly the same number of units of the good as the sellers are willing to sell, and consequently, buyers will be able to find as many units as they want to buy, and sellers will be able to find as many customers as they can sell all the units they want to sell to, and sellers will have no reason either to reduce or to raise their prices.

40. Such a situation is called an equilibrium.
Therefore, the price in this situation (or the price at the intersection of D and S curves) is called the equilibrium price, Pe,
and the quantity bought and sold in equilibrium is called the equilibrium quantity, Qe.
Naturally, we have
QD(Pe) = Qe
and
QS(Pe) = Qe.

41. The term equilibrium is used for two reasons:
(1) There is an equality between QD and QS
(2) There is no tendency for P to change.
whereas we would be talking about a disequilibrium situation if P had been above or below Pe as in the previous two cases.
In other words, surpluses or shortages are disequilibrium situations
in which the inequality between QD and QS creates a tendency or pressure for P to change.

42. In perfectly competitive markets, prices will move toward their equilibrium values as long as there are no conditions (such as price controls imposed by the government) preventing the prices from changing.
The speed by which prices move toward equilibrium changes from market to market.
For example, prices move very quickly in financial markets, somewhat quickly in markets for agricultural goods, relatively less quickly or relatively slowly in markets for industrial goods, and significantly slowly in labor markets.

43. If the price in a market moves very quickly toward the equilibrium whenever there is a disequilibrium, we can consider that market to be practically in equilibrium all the time throughout each given period of time.
In other words, we can view actual prices observed in that market to be practically the same as the equilibrium prices.
In the rest of this lecture we will consider a market in which the price moves to equilibrium fast enough to view that market to be in equilibrium all the time.
This means that we will consider a market in which the prices can be explained by equilibrium prices.

44. This means that we will explain the changes in the price by changes in the equilibrium of the market.
But why and how does the equilibrium in a market change?
This is the question whose answer we will study next.
Before we start trying to answer this question, notice that such a study will be useful also for explaining or predicting the direction (if not the amount) of the change in the price in a market which does not come to equilibrium so quickly.